Intensity Gamma: A New Approach to Pricing Portfolio Credit Derivatives
by Mark Joshi of the Royal Bank of Scotland, and
May 11, 2005
Abstract: We develop a completely new model for correlation of credit defaults based on a financially intuitive concept of business time similar to that in the Variance Gamma model for stock price evolution. Solving a simple equation calibrates each name to its credit spread curve and we show that the overall model can be calibrated to the market base correlation curve of a tranched CDO index. Once this calibration is performed, obtaining consistent arbitrage-free prices for non-standard tranches, products based on different underlying names and even more exotic products such as CDO 2 is straightforward and rapid.
Keywords: CDO, correlation smile, gamma process, CDO-squared.
Published in: RISK, Vol. 19, No. 9, (September 2006), pp. 50-55.